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Japan Through the Looking Glass

November 16, 2014 2:14 pmNovember 16, 2014 2:14 pm

There are indications that Shinzo Abe may indeed do the right thing and postpone the planned rise in Japan’s consumption tax. Let’s hope so. But many people are still treating this as an agonizing choice. For example, Gavyn Davies frames it as a choice between recovery and fiscal sustainability, although he sort of acknowledges that this may be a false dilemma.

Several points here.

First, unless Japan breaks out of deflation, and the artificially high real interest rates this causes, there is no way to achieve fiscal sustainability. Success for Abenomics is as crucial for fiscal matters as everything else.

Second, everyone acknowledges that the impact of a delayed sales tax increase on Japan’s debt would be trivial — less than one percent of GDP. So why is this supposed to be something to worry about? Supposedly, Japan would lose credibility.

Actually, that’s unlikely — I see no prospect that Japan will put off the tax hike forever. But even if it were true, this is credibility Japan wants to lose.

After all, suppose investors conclude that Japan will never raise taxes enough to service its debt. What would they think would happen instead? Not default — Japan doesn’t have to default, because its debts are in its own currency. No, what they might fear is monetization: Japan will print lots of yen to cover deficits. And this will lead to inflation. So a loss of fiscal credibility would lead to expectations of future inflation, which is a problem for Abe’s efforts to, um, get people to expect inflation rather than deflation, because … what?

Long ago I argued that what Japan needed was a credible promise to be irresponsible. And deficits that must be monetized are one way to make that happen (as they were in the 1930s, when Japan had a very successful comeback from the Great Depression, aside from that invading China thing.)

As I and other people like Paul McCulley have tried to explain many times, the liquidity trap puts you on the other side of the looking glass; virtue is vice, prudence is folly, central bank independence is a bad thing and the threat of monetized deficits is to be welcomed, not feared.

As it happens, I don’t think this stuff will come into play in Japan, where the Ministry of Finance’s deficit obsession ensures that tax hikes will at best be delayed, not canceled. But the whole premise of those who fear the consequences of delay misses the point.